In a capped floater swap:
The capped leg pays a floating rate that is limited by a specified cap and/or floor. This leg never pays less than the defined floor or more than the defined cap.
The other leg pays a regular floating or fixed rate.
In return for receiving the capped leg, the party receiving this leg also receives a positive spread to the floating rate. In effect, this positive spread is like receiving a periodic premium.
There are two styles of capped floater swap, the difference between them being in whether the swap can be terminated (or called). In a:
Non-callable style capped floater swap the swap cannot be called.
Bermudan style of capped floater swap (also known as a callable capped floater swap):
The payer of the capped leg has the right but not the obligation to terminate the deal on any of the predefined dates after the predefined lockout date.
Once the instrument is cancelled, both sides must pay any interest owed up to the effective date of the cancellation.
Advantages of a Capped Floater Swap
Defining a cap for this instrument allows an investor to express a view on the maximum level that a floating rate will reach. An investor who believes that:
The floating rate is likely to rise beyond the cap will elect to pay the capped leg (i.e., to pay the capped payout). The investor is therefore assured of not having to pay more than the cap.
The floating rate is not likely to rise beyond the cap will elect to receive the capped leg. The investor is rewarded for accepting this risk by receiving a positive spread on the floating rate, and thus receives a higher rate than would be received in a vanilla swap.
Defining a floor for this instrument allows an investor to express a view on the minimum level that a floating rate will reach. An investor who believes that:
The floating rate is likely to fall beyond the floor will elect to receive the capped leg (i.e., to receive the floored payout). The investor is therefore assured of not having to receive less than the floor.
The floating rate is not likely to fall beyond the floor will elect to pay the capped leg (i.e., pay the floored payout). The investor is rewarded for accepting this risk by paying a negative spread on the floating rate, and thus receives a lower rate than would be paid in a vanilla swap.
Why would you define a cap and a floor? If you are receiving the capped leg, depending on your view you may want to define a high floor in order to protect yourself against falling rates. However, this condition costs money, as it results in a negative spread. So in order to offset that negative spread you can simultaneously define a cap of sufficiently low level, which would in and of itself raise the spread.
Why would you make the instrument callable? Making the instrument callable offers the following advantages:
An issuer would enter into this instrument as a hedge (or swap) against callable debt.
For example, the issuer has issued a callable range accrual bond to a group of investors and protects this issuance with a callable range accrual swap (done with a swap dealer).
The issuer receives the structured leg (which is structured to mirror the structured bond cash flows) and pays an interest rate which is lower than he would through issuing non-structured bonds.
An investor enters into this instrument to enhance yield. That is because, in order to compensate for the risk that the other party may cancel the swap (as well as the risk embedded in the coupon formula) the interest rate is preferential to the rate that would be received on a vanilla investment.
Disadvantages of a Capped Floater Swap
If the capped floater swap is callable the disadvantages are as follows:
If interest rates in the market improve from the point of view of the investor, the payer of the structured leg will call the swap and the investor will then have to enter into another investment with a less favorable interest rate.
If interest rates in the market worsen from the point of view of the investor, the investor is locked into receiving lower coupons.
Pricing a Capped Floater Swap in SDX Interest Rates
When pricing a capped floater swap in SDX Interest Rates, in addition to the standard fields for vanilla swaps, the following must be specified:
The floating spread paid on the capped leg.
This is calculated by the system and displayed in the Floating Spread result in the Results area. However, you can also define this manually and then recalculate the instrument.
The cap and/or the floor on the floating rate paid by the capped leg.
Whether the capped floater swap is a Bermudan or non-callable style.
For a Bermudan style, the first call date and subsequent call dates.
The first call date is displayed in the First eff. call date field, and defines the first date on which the owner of the right to cancel can cancel the swap. By default this is set to match the start date of one of the underlying coupons and the system then sets the remaining call dates to the start dates of the remaining relevant coupon periods (according to the call frequency).
You can see and edit the remaining call dates in the Callable Dates and Fees window. For more information on working with this window, see Working in the Callable Dates and Fees Window.